Norges Bank Watch 2001
A review of inflation targeting, the Norwegian monetary regime and its institutional arrangements, and Norges Bank’s actual monetary policy
and communication
Chief economist Harald Magnus Andreassen First Securities ASA
Professor Paul De Grauwe Katholieke Universiteit Leuven
Candidate for the doctorate Haakon Solheim Norwegian School of Management
Associate Professor Øystein Thøgersen,
Norwegian School of Economics and Business and Administration
Research Report 13/2001
Norwegian School of Management BI Department of Economics Centre for Monetary Economics
Harald Magnus Andreassen, Paul De Grauwe, Haakon Solheim, Øystein Thøgersen:
Norges Bank Watch 2001
© Authors 2001
Research Report 13/2001 ISSN: 0803-2610
Norwegian School of Management BI P.O.B. 580
N-1302 Sandvika Phone: +47 67 55 70 00 Printing: Nordberg Hurtigtrykk
To be ordered from:
Juul Møller Bøker Phone: 67 55 74 51 Fax: 67 55 74 50 Mail: jmbok@online.no
Preface
This is the second Norges Bank Watch by the Centre for Monetary Economics (CME) at the Norwegian School of Management. However, as last year's report was written in Norwegian, this is the first one accessible to a wider audience.
On 29 March 2001 Norges Bank was formally given an inflation target - as recommended in last year's Norges Bank Watch.
The present Norges Bank Watch discusses asset price developments and interest rate determination in general terms. More specifically, the report analyses the implementation of an inflation target in Norway.
The team responsible for the report consists of chief economist Harald Magnus Andreassen, professor Paul De Grauwe, doctoral student Haakon Solheim and associate professor Øystein Thøgersen. The group is solely responsible fort the report and the views presented here.
We greatfully acknowledge financial support from CME member firms:
ABB Financial Services AS Alfred Berg Norge ASA Awilco ASA
BN-Bank
Christiania Fonds AS Citicorp.
DnB Markets
Finansnæringens Hovedorganisasjon First Securities ASA
Fokus Bank Folketrygdfondet Fondsfinans AS Handelsbanken Industrifinans Kredittilsynet Norsk Hydro ASA Pareto Securities Petter Olsen Finans AS SEB Enskilda Banken Skandia Fondsforvaltning Sparebanken/Gjensidige NOR Sparebankenes Kredittselskap A/S Sparebankforenings Servicekontor Sparebankgruppen AS
Statoil Storebrand Telenor
Sandvika, October 2001 Centre for Monetary Economics Arne Jon Isachsen
Table of content
i9
1. Summary 9
2. Flexible inflation targeting 13
2.1 Flexible inflation targeting: the emerging new consensus 13
Box 1. More on inflation targeting 15
2.2 Flexible inflation targeting: The theory 17 2.3 Flexible inflation targeting: Some challenges to the consensus
view 20
2.5 A two-stage strategy for the central bank 22 3. Norges Bank and the conduct of monetary policy in Norway 25 3.1 The institutional framework of Norges Bank 25
3.2 The monetary policy guidelines 28
3.3 The Norwegian system compared with best practice 29 3.4 The focus on nominal exchange rates and the inflation targets
– is the economic policy guidelines consistent in the long term? 33 4. Can the high Norwegian interest rates be justified? 35 4.1 Norwegian nominal and real rates are higher than in Euroland 35 4.2 The short-run macroeconomic picture - Binding capacity
constraints 36
4.3 The long run interest rate differential – Is the inflation target
credible? 39
5. Evaluating the forecasts and instrument/policy changes of Norges
Bank from June 2000 to August 2001 43
5.1 The bank’s objectives 43
5.2 Forecasts of mainland GDP and inflation for 2001 and 2002 45 5.3 Assessing changes in monetary policy instruments 50
Box 2. International uncertainty 54
5.4 Changes in interest rates, the level of interest rates and inflation 55
5.5 CPIXE – core inflation 57
6. Communicating with the public 59
References 60
1. Summary
March 29 2001 the Norwegian government introduced a new regulation of monetary policy in Norway. The new regulation states that
“Norges Bank’s implementation of monetary policy shall […] be oriented towards low and stable inflation. The operational target of monetary policy shall be annual consumer price inflation of approximately 2.5 per cent over time.”
This is a formalisation of an inflation target for Norges Bank.
In this report we will focus on the challenges of an inflation target. The first part of the report focuses on the possibilities and limitations in a flexible inflation targeting approach. The second part focuses on the implementation of an inflation target in Norway.
Flexible inflation targeting
In the first section of the report we present the main arguments in favour of flexible inflation targeting as the optimal monetary regime. Flexible inflation targeting concentrates on stabilising inflation. However, as there usually is a close connection between the level of economic activity and the inflationary pressures this should also contribute to output stabilisation. If aggregate demand is too high compared to actual production capacity, both wage pressures and margin increases will usually lead to higher inflation. If demand is too low, recessions and deflation are the usual outcome. When central banks try to influence domestic demand by adjusting its interest rates in order to stabilise future inflation, its aim is to achieve a good balance between aggregate demand and supply in the economy. This demand smoothing will naturally lead to a stabilising of the real economy and keeping unemployment at the lowest possible level without igniting inflation. International experiences with this policy have been reasonably good.
However, economic imbalances might emerge without creating any consumer price inflation problems, at least in the short or medium term.
Major economic boom and bust periods have been driven by inflation and deflation in stock and property markets, usually closely connected to credit growth. In boom periods, demand gets a boost due to increased optimism about future rates of return. The supply side responds by increasing investments and thereby capacity. As both consumption and investment growth are partly financed by increasing net debt, the economy becomes unstable. As debt levels become high the economy gets more vulnerable to
shocks. When the cycle turns both consumption and investments contracts.
A boom turns into a bust.
As expected prices are not affected, a flexible inflation target does not imply any response to such fluctuations in output. Therefore the central bank also needs to take other factors into regard in order to assure that it gets a complete picture of the economic developments. Central banks can, and should in our opinion, take asset prices and debt accumulation into consideration when they conduct their monetary policy.
The “traditional” inflation targeting must be the main focus. However, the central bank should monitor debt developments and asset prices closely.
Asset prices can and should not be targeted, as it is always difficult to judge how asset price inflation is transmitted into the real economy. But central banks can and should “lean against the wind” when asset prices and credit growth deviate substantially from their normal paths. In such situations, asset price or debt market considerations might overrule the policy indicated by a pure inflation targeting analysis. Central banks should prepare themselves for handling such mixed signal situations, even if they probably are rare.
Are the Norwegian institutions up to date?
The new policy guidelines formalise a new role for Norges Bank, but the institutional framework, given in the Central Bank law, was not changed.
Internationally, the central bank’s formal and real independence from other authorities and the need for economic competence in the decision-making bodies have been stressed as important success criteria for an inflation target regime.
The current practice of monetary policy in Norway fulfils most of the criteria of a “best practice” inflation targeting bank. However, one should be aware that the Central Bank law was written with a fixed exchange rate regime in mind.
Three issues are discussed in more detail: the right of instruction included in the law, the composition of the decision making Executive Board, and the desirability of publishing the minutes of Board meetings. Neither of these implies an immediate threat to the credibility of the current regime.
However, to assure the long-term stability of an inflation target institutional changes need to be made. As a first step, the report suggests certain adjustments in appointing members to the Executive Board. Today, candidates are nominated by political parties. In the future, it is important that candidates to the Board have the qualifications to make the Board a
demanding reference body for the Bank’s administration. A well-qualified and representative Board can assure that the public remains confident in the Bank’s analysis.
The Norwegian inflation target at 2.5 per cent is relatively high. As a comparison the inflation target in Euroland is currently 2 per cent (as a maximum), and the inflation target in Sweden is 2 per cent. However, according to the monetary policy regulation the nominal exchange rate is still expected to be stable. The expected increase in domestic spending of oil revenues will most likely lead to a need for a real appreciation of the Norwegian krone in order to reduce the production, employment and profitability in the sectors exposed to foreign competition. Norges Bank Watch believes that Norges Bank’s assessment of the need for real appreciation would be of great interest. This assessment should include answering the question whether the current ½ per cent “automatic” real appreciation is appropriate given alternatives for fiscal policy.
Has the bank been successful in conducting its monetary policy?
A central bank’s monetary policy within an inflation targeting regime can be evaluated by formulating three question. First, have the analysis of the economic development and inflation forecasts been reasonable, given the information available when the forecasts were made? Second, has the bank set its interest rates in accordance to the analysis? And third, has the bank reached its inflation targets?
Even if the formal inflation target was not implemented before March 2001, the bank’s interpretation of its mandate from early 1999 as an inflation target regime gives us the ability to evaluate Norges Bank according to these three questions.
Norwegian interest rates have been very high compared to interest rates in most other countries. However, during this period the Norwegian economy has operated close to, and in some periods above, its long term production potential due to a high level of domestic demand. At the same time, the level of activity has stayed below potential output in parts of Euroland. According to Norges Bank’s assessment there has been no room for lower rates without increasing the risk for inflation. By and large, other observers of the Norwegian economy have shared this analysis, and Norges Bank Watch agrees. However, there is currently a substantial uncertainty tied to the international economic outlook. An international downturn should also affect Norway. We therefore do not believe that Norges Bank will allow the interest differential to increase much more. Nevertheless, a still tight labour market, and the outlook for a more expansionary fiscal policy should imply
that short-term Norwegian interest rates will remain above other European rates for a long time.
If domestic demand is boosted by increased spending of oil revenues there are arguments in favour of expecting Norwegian real interest rates to remain higher than abroad on a permanent basis. A tight monetary policy is a necessary ingredient in the structural transformation process. High interest rates dampen interest sensitive domestic demand. However, in such a scenario the exchange rate appreciation might come quite rapidly. If so, inflation pressure will be dampened.
In the recent months we have seen an increasing interest rate differential for long-term government bonds. This might reflect uncertainty about future Norwegian inflation. However, we find that there are several alternative (and in our view more credible) explanations; including the cost of hedging in the Norwegian market, and higher expected real interest rates in Norway.
Communication
The report concludes that Norges Bank has a firm and credible commitment to fulfilling the inflation target. The Bank enjoys a good communication with both the public and the financial markets. The Inflation Report, currently published three times a year, is a clear and well-written exposition of the Banks expectations and judgements and Norges Bank has demonstrated the ability to clarify its policy through articles and speech
2. Flexible inflation targeting
2.1 Flexible inflation targeting: the emerging new consensus
A new consensus has emerged about the optimal design of monetary policy.
This new consensus can be summarised in four points (see box 1 for more detail).
• The primary objective of the central bank is to maintain price stability. The central bank should not aim at permanently increasing economic growth or reducing unemployment. Such ambitions cannot be realised by the central bank. Instead if pursued, they will lead to accelerating inflation. Conversely by maintaining price stability the central bank does the best it can to maximise long run economic growth.
The underlying reason is that economic growth (and employment) in the long run depends solely on real factors.
• The objective of price stability applies to the medium run (say over a period of 2 years). Thus when inflation exceeds the target, the central bank should be allowed to bring inflation back to target in a gradual manner. Such a gradual adjustment adds flexibility to inflation targeting giving room for the central bank to stabilise output. It has been shown by Svensson (1997) that flexible inflation targeting is broadly speaking the same as explicit output stabilisation.
• With flexible inflation targeting there is no need for the central bank to pursue active stabilisation of output per se. Stabilising the rate of inflation around its target in a gradual manner has the happy effect of also stabilising output around its capacity level (see Alesina, et al.
(2001) for a recent statement of this view). We note that the term gradual is important in this respect.
• In a regime of flexible inflation targeting, the central bank should react to shocks (e.g. shocks in output, shocks in the exchange rate, etc.) only to the extent these shocks affect the rate of inflation.
The new consensus about how monetary policies should be conducted goes further than the four points mentioned here. It extends to the political and institutional environment in which the central bank should operate. In this new consensus flexible inflation targeting can only be successful in the long run if three institutional conditions are met:
1. The central bank should operate in an environment of political independence. Independence has two dimensions, instrument indepen- dence and goal independence. There is a general consensus that
instrument independence is a necessary condition for a successful inflation targeting. It can be said to belong to best practice inflation targeting. That is, a central bank must be able to set its instrument for conducting its policies independently from political interference. There is less consensus about goal independence.
2. The policy regime should be transparent. The publication of the inflation report is one element in this transparency. Transparency can be enhanced by the publication of the minutes of the meetings of the body that decides about the interest rate. It is still a matter of controversy whether or not such a publication improves the quality of policy making.
3. Inflation targeting necessitates a framework allowing central banks to be made accountable for their policies. The way the accountability is organised differs from one country to the other. It consists of two elements. The first one is to require that the President (Governor) of the central bank explains policies and possibly failures in these policies to the parliament or to the government. The second component consists in a sanctioning procedure when the Central Bank consistently fails to achieve the target for inflation. Few countries have an explicit sanctioning procedure.
There is an interaction between flexible inflation targeting and political independence. Flexible inflation targeting is a simple policy rule that allows for an easy implementation. The ease of implementation has the effect that society has to worry less that the independence granted to the central bank will be misused. The simple rule makes it possible to control the performance of the central bank, and thus to make it accountable.
Flexible inflation targeting is on its way to becoming the new conventional wisdom in monetary policy-making, not the least because it has turned out to be quite successful in many countries.1 Can we consider this to be a new and permanent improvement in the way monetary policy is conducted, or is flexible inflation targeting a passing fad, much like money stock targeting has been? We analyse this issue in the next sections. In order to do so we first study the central claim made by the proponents of flexible inflation targeting, i.e. that this strategy if properly applied keeps inflation low and contributes to output stabilisation.
1 For recent empirical evidence, see Mishkin and Schmidt-Hebbel (2001).
Box 1- More on inflation targeting
Best practice inflation targeting
A new monetary policy regime has emerged that is slowly making its way as the new model for the conduct of monetary policy. This model has been called “flexible inflation targeting”. It has emerged as the result of new theoretical insights together with practical experimentation by an increasing number of central banks. We analyse the main ingredients of this model stressing those features that can be called “best practice”.
The central feature of flexible inflation targeting can be described as follows (figure B.1 for a concise representation).
1. The primary objective of the central bank is the maintenance of price stability. This leads to the formulation of a numerical target. There is a consensus that the numerical value of this target should be between 2 and 3 per cent. The best practice view is that there should be some symmetric error band around this numerical target, say 1per cent. This is what most central banks that apply inflation targeting do. Thus Norges Bank has set a target of 2.5 per cent with an error of + and - 1per cent. A major exception to this approach is the ECB, which has defined the target as a maximum inflation rate (2 per cent). The latter approach has been criticised for its asymmetric nature (see Svensson(1998)).
2. It is desirable that the inflation targeting procedure should not react to movements in the price index that are temporary or the result of special factors. Therefore, many central banks use a concept of core inflation.
3. The central bank makes a forecast of the future inflation over the medium run, typically 2 years. This forecast is based on a model of the economy and is made public. This usually takes the form of the publication of an inflation report, typically issued three or four times a year. The inflation report contains an analysis of the forces that determine future inflation. In addition, it presents the forecast of inflation together with an estimate of a confidence band. The latter allows the public to evaluate the uncertainty surrounding this forecast. In a way, it can be said that the inflation forecast plays the same role of the intermediate target in a money stock targeting strategy.
4. The instrument used by the central bank is the short-term interest rate.
The procedure to adjust the interest rate starts from a comparison of the inflation forecast with the inflation target. When the inflation forecast exceeds the target the central bank raises the interest rate; when it is below the target the central bank is supposed to lower the interest rate. cont.
5. A distinction has been made between strict and flexible inflation targeting.
In the former the central bank has only one objective, i.e. inflation. In the latter the central bank also gives some weight to other objectives, typically the output gap or some measure of unemployment. It has been shown by Svensson(1997) that a strategy consisting in only targeting inflation but allowing for a gradual adjustment of the observed inflation towards its target is equivalent to a strategy in which the central bank explicitly targets the output gap. There is a growing consensus that such a flexible inflation targeting procedure constitutes best practice (see Alesina et al. (2001). Most central banks have not been very explicit about the length of time allowed for the gradual adjustment. There is some consensus that this can be anything between one and two years.
Figure B.1
________________________________________________________
Instrument information used objective (intermediate target) (numerical target) ________________________________________________________
short-term inflation forecast inflation
interest rate
________________________________________________________
6. Inflation targeting as described in the previous section can only be successful in an institutional environment of political independence of the central bank. Independence has two dimensions, instrument independence and goal independence. There is a general consensus that instrument independence is a necessary condition for a successful inflation targeting. It can be said to belong to best practice inflation targeting. That is, a central bank must be able to set its instrument for conducting its policies independently from political interference. The practical implication of this instrument independence is that the minister of finance (or other representatives of the government) has no say in the decisions to change the interest rate. There is less consensus about goal independence. In some countries the government sets the numerical objective for inflation (the UK), so that the central bank has no goal independence. In other countries the numerical objective for inflation is decided by the central bank itself (Euroland). There is no consensus about which of the two regimes for setting the numerical objective is to be preferred. cont.
7. The success of inflation targeting also depends on the degree of transparency of the policy regime. The publication of the inflation report is one element in this transparency. Transparency can be enhanced by the publication of the minutes of the meetings of the body that decides about the interest rate. It is still a matter of controversy whether or not such a publication improves the quality of policy making, so that it would be premature to label such a publication best practice.
8. Inflation targeting requires independent central banks. It also necessitates a framework allowing central banks to be made accountable for their policies. The way the accountability is organised differs from one country to the other. It consists of two elements. The first one is to require that the President (Governor) of the central bank appears before the parliament (ECB) to explain policies and possibly failures in these policies. In some countries the explaining is done differently in the form of a communication with the government (Bank of England). The second component consists in a sanctioning procedure when the Central Bank consistently fails to achieve the target for inflation. The Bank of New Zealand has gone the farthest in this, by making it possible to sack the President of the Bank. Most of the other countries do not have an explicit sanctioning procedure.
2.2 Flexible inflation targeting: The theory
The central claim made by the theory of flexible inflation targeting is that this policy regime makes it possible for the central bank not only to stabilise the price level, but also to do the best possible job in stabilising output around its capacity (“natural”) level. The claim that flexible inflation targeting also stabilises output is quite obvious when shocks originate from the demand side. This is illustrated in figure 2.1, which represents the aggregate demand and supply curves in the inflation-output space3. It is assumed that there are positive and negative shocks in aggregate demand.
This represented by the ADU and ADL curves. Capacity output (the “natural”
output level), y*, is represented by a vertical line. The central bank cannot and does not try to influence this “natural” output level, which is determined
2 For recent empirical evidence, see Mishkin and Schmidt-Hebbel (2001).
3 The analysis can also be done in the price-output space with essentially the same results.
y*
π*
output ADL AD
ADU
by productivity growth, labour supply and the size of the real capital stock (i.e. y* is influenced by structural policies, but not by monetary policy).4
-Flexible inflation targeting now implies that the central bank sets a target inflation rate, π*. In a boom (ADU ) the central bank raises the interest rate so as to lower the AD curve. In a recession it does the opposite. Because prices are sticky the central bank allows for a gradual adjustment of inflation and output. It can immediately be seen that this strategy of stabilising inflation around π* also stabilises output around y*. In other words when the central bank follows a flexible inflation targeting strategy there is no need to explicitly target the output gap. This is good news because output gap statistics tend to be very unreliable (see Orphanides(2000)).
Figure 2.1: Flexible inflation targeting and demand shocks
Does this analysis also carry over to supply shocks? The answer is positive.
We show this in figure 2.2. We assume that, due to a wage cost increase or an increase in energy prices, the supply curve shifts upwards from AS1 to AS2. We assume this to be a permanent shock so that capacity output is also lowered, from y*1 to y*2. After this supply shock, the short-term equilibrium
4 As is well-known there is a large literature based on the Barro-Gordon model analysing time inconsistency problems that arise when central banks attempt to increase the natural output level (reduce the natural unemployment rate).
inflation
AD AS1
AS2
A π
π*
y*2 y*1 y
position is in point A. Output exceeds capacity output (the output gap is positive) and inflationary pressure is generated. Because it targets inflation (at the level given by π*) the central bank reacts in the correct way, i.e. it raises the interest rate so as to gradually bring aggregate demand to the level consistent with a reduced level of capacity output. Put differently, inflation targeting is equivalent to stabilising output around its new “natural” level.
We conclude that in the case of a permanent supply shock, focusing on the inflation rate is the correct policy. There is no trade-off for the central bank between stabilising output and stabilising inflation in the intermediate and long run. At least for a central bank that takes the view that it can do nothing to change the natural level of output (or the natural unemployment rate).
Figure 2.2: Flexible inflation targeting and supply shocks
A distinction should be made between permanent supply shocks (analysed in figure 2) and temporary supply shocks. The latter only involve shifts in the short-term aggregate supply curve. According to the proponents of inflation targeting the correct response of the central bank is to formulate its targeting strategy in terms of “core inflation” – as in the Norwegian case but not in the case of the ECB. This allows disregarding the effects of temporary supply shocks on inflation. The issue that remains here is whether the central bank
BOOM
BUST π
y
y*1 y*2
is always able to distinguish between permanent and temporary supply shocks. In practice this may sometimes be difficult. As a result, inflation targeting will not prevent central banks from making major policy errors.
2.3. Flexible inflation targeting: Some challenges to the consensus view
The model underlying the emerging consensus in favour of flexible inflation targeting is simple and quite attractive. It has also become the standard macro-economic model used in classrooms and has gained a wide acceptability (see Clarida, Gali and Gertler (1999) for its use by neo- Keynesian economists). Its main feature is that demand and supply decisions are only influenced by present and expected goods prices and wages. This may be a serious shortcoming. In this section we show that if demand and supply decisions also depend on assets and on their valuation, volatility in output can be generated that does not show up in volatility of inflation, so that the close link between inflation variability and output gap variability breaks down.
In order to analyse this problem we develop a scenario of boom and bust generated by movements in asset prices. We show the analysis in figure 2.3.
Figure 2.3: Inflation targeting in boom-and-bust scenario
Suppose a bubble arises in the stock market (or alternatively in the real estate market). This could be due to a perception that new technologies will lead to higher growth in the future (Japan in the 1980s, the US in the 1990s), but it can also be due to other factors (e.g. Scandinavian countries during the second half of the 1980s). As a result of these positive expectations about future growth, consumers have an incentive to spend more. The only way they can do this is by increasing their debt position. Similarly firms, gripped by the same “animal spirits”, evaluate the future optimistically. This has the effect of raising the present value of future expected rates of return on investment. As a result, investment activity increases, which raises capacity output.
The effect of all this is to create a boom characterised by increases in aggregate demand and supply. We show this in figure 3. Thus, during the boom phase, the output gap is unaffected, and there are no inflationary pressures5. The central bank, which follows an inflation targeting strategy, does not react. It has no reason to do so because its inflation forecasting exercise tells it that because of the simultaneous increase in demand and supply (productivity and/or excess capital formation) no inflation is to be expected in the future.
After the boom comes the bust. The latter is typically produced by excessive debt accumulation of both consumers and firms. Debt deflation is set in motion and this results in a decline of aggregate demand. At the same time, however, producers find themselves with excess capacity, which leads them to disinvest. Capacity output declines.
Like in the boom phase, during the bust phase the output gap is unaffected, and so is inflation. As a result, the inflation targeting central bank does not intervene. Yet there will be great volatility of output. We conclude that the one-to-one correspondence between inflation variability and output variability breaks down in a world where demand and supply decisions are influenced by assets and asset prices.
Another way to formulate the problem is as follows. Demand and supply decisions are influenced not only by flow variables (goods prices and wages) but also by assets and their valuation. Both the wealth of the consumers and the present value of the investment projects depend on the expectations of future rates of return of capital. This leads to the possibility of self-fulfilling
5 This should not be interpreted literally. The point is that an asset driven boom raises demand and supply, so that its effect on inflation is of second order.
expectations. When agents are optimistic about the future they will forecast large rates of return. As a result, the value of assets increase, i.e. wealth of consumers increase because the stock prices reflecting these positive expectations increase. Similarly investors will calculate higher present values of the investment projects, so that the value of the firm increases. This then raises today’s demand for consumption, and it stimulates investment activity. The latter increases potential output. Thus demand and supply increase with little effect on inflation.
It also follows that when the central bank targets the rate of inflation, this is consistent with infinitely many paths for output of goods and services.
Inflation targeting is insufficient to tie down a unique output path. The output paths will be determined by the path taken by asset values, which in turn are determined by expectations. In order to determine a unique output path the central bank must also tie down asset values. How can this be done? We analyse this question in the next section where we suggest that the Central Bank should present an explicit strategy for how it intents to deal with asset price inflation.
2.5. A two-stage strategy for the central bank
Because of cycles in asset valuations (notably in real estate prices in the Norwegian case), cycles in output are generated that do not lead to changes in inflation. Therefore, a central bank that gives some weight to output stabilisation cannot be content of just following a flexible inflation targeting strategy, which only reacts to those shocks that affect current and future inflation. It must also have an eye on other variables even if these variables do not affect current and future inflation. What are these variables?
In order to answer this question it is important to realise that consumers and investors who react to increasing asset values can only increase their spending by borrowing, domestically or abroad. Thus the natural asset variable to be monitored by the central bank is total credit to the private sector. This leads to the formulation of a “two-stage“ strategy. This strategy can be described as follows:
• The first and main stage is flexible inflation targeting which has been described earlier, and which is now used by an increasing number of central banks. It must remain in place. It is the pillar that has to be used in normal times.
• The additional stage consists in monitoring credit aggregates. It requires the central bank to monitor a number of credit aggregates, and to
intervene and possibly to overrule the signals given by the first stage.
One would expect that this would not happen frequently. In normal times it will remain unused. At the same time one can say with certainty (and with reference to the experience from the U.S. lately) that central banks will at some point in the future be confronted with the need to use the second stage. Note that the money stock can also have a useful role in this context.
Several readers will note that the ECB has formulated a two-pillar strategy with similarities to our two-stage strategy. Ours, however, is quite different in nature. In contrast to the ECB strategy, ours gives a privileged role to inflation targeting (first stage) and complements it with a second stage that aims at checking unsustainable developments in the value of financial stocks (credit aggregates, money stock).
Several points should be stressed about this strategy. First, in addition to credit aggregates, useful information for the implementation of the second stage can be obtained from asset prices (e.g. real estate prices and stock prices). This has been recommended by a number of influential economists recently (see Goodhart(2000), Checchetti, et al. (2000)). Second, the practical implementation of the two-stages must be quite different. Inflation targeting can be implemented in a very precise way, i.e. by specifying a precise numerical target and by monitoring how close inflation has stayed to this target. No such precision is possible when monitoring assets and asset prices. More judgement is necessary. This lack of precision is due to our lack of knowledge of how asset inflation is transmitted to the real economy. It is also hard, ex-ante, to assess whether given asset price levels are sustainable or not. The lack of precision also calls for using “leaning against the wind”
rules when monitoring assets and asset prices, rather than targeting particular numbers.
We conclude that central banks will have to use a two-stage strategy, i.e. a strategy consisting of flexible inflation targeting complemented by a strategy aimed at tying down asset values. Failure to do so, will sooner or later confront the central banks with the problem of large disturbances in output that they did not see arriving on their “inflation targeting radar screens”.
3. Norges Bank and the conduct of monetary policy in Norway
When the regulation of monetary policy was changed earlier this year the institutional framework of Norges Bank was not adjusted. We will give a short description of how the Norwegian system works, and then discuss whether this system needs to be attuned in light of the recent changes in monetary policy.
3.1 The institutional framework of Norges Bank
The law governing central banking in Norway was issued in 1985. Section 2 describes the relationship between the bank and the government.
• “The Bank shall conduct its operations in accordance with the economic policy guidelines drawn up by the government authorities and with the country's international commitments.
• Before the Bank makes any decision of special importance, the matter shall be submitted to the ministry.
• The Council of State may adopt resolutions regarding the operations of the Bank. Such resolutions may take the form of general rules or instructions in individual cases. The Bank shall be given the opportunity to state its opinion before such resolutions are passed. The Storting shall be notified of resolutions as soon as possible. […]”6
The obligation for the Bank to “conduct its operations in accordance with the economic policy guidelines drawn up by the government authorities” is in line with the rules governing e.g. Sveriges Riksbank. In countries with an inflation targeting regime the economic policy guidelines for the bank is a statement about a specific inflation target. We will return to the Norwegian economic policy guidelines below.
The obligation to inform the government of important matters in advance is standard in inflation targeting regimes. The right of instruction can however be seen as a Norwegian “anomaly” when compared with current “best practice”.
The right of instruction must be understood in terms of the fixed exchange rate regime at the time the Central Bank law was written, and a Norwegian
6 All translations are from Norges Bank.
tradition of a close contact between the Ministry of Finance and Norges Bank imposed by central bank governors after the Second World War.7 It is important to notice that the right of instruction comes with two check: the Storting must be informed as soon as possible, and Norges Bank is obliged to state its opinion on the matter.8 These checks are imposed to guarantee a public discussion if the right to instruct is used. There has been an argument of how this law was supposed to be applied (see Carsten Smith, 1994, for a discussion). However, the understanding today seems to be that if the Government instructs Norges Bank to act in opposition to the best judgement of the Bank, the Governor of Norges Bank will leave office. It is therefore reasonable to see the right of instruction as nothing more than a formal statement of the government’s final say in all economic policy questions.
The right of instruction has never been formally used.9
Section 5 –7 discusses the organisation of the bank. Section 5:
• “Supreme authority in the Bank is vested in an executive board and a supervisory council.
• Under this Act, executive and advisory authority is vested in the Executive Board. The Board is in charge of the Bank's operations and manages its funds.
• The Supervisory Council ensures that the rules governing the operations of the Bank are observed. […]”
Section 6:
• “The Executive Board consists of seven members, appointed by the government (formally the King) . The Governor and Deputy Governor shall be the chairman and deputy chairman of the Executive Board. They are appointed to full-time positions for terms of six years.
Reappointment to the same position may take place for one period of a
7 This was partly a response to the “back to gold parity” policy followed by a very independent central bank policy in 1920’s and 30’s.
8 Norges Bank’s obligations are made clear in section 3:
• “The Bank shall state its opinion on matters that are put before it by the Government or the ministry.
• The Bank shall inform the ministry when, in the opinion of the Bank, there is a need for measures to be taken by others than the Bank in the field of monetary, credit or foreign exchange policy.
• The Bank shall inform the public about the monetary, credit and foreign exchange situation.”
9 Christiansen (2001) argues that the change from an exchange rate target to an inflation target was an instruction of Norges Bank. It is however more natural to see this as a change in the economic policy guidelines of the government than as an instruction.
further six years. The other five members are appointed for four-year terms. Every other year, two - alternately three - members retire. These members may be re-appointed for a total period of twelve years. […]”
Section 7:
• “The Supervisory Council: The Supervisory Council consists of fifteen members elected by the Storting for four-year terms. Every other year, seven - alternately eight - members retire. From the members the Storting elects the chairman and deputy chairman for terms of two years.
By re-election, members may serve for a total period of twelve years.
[…]”
Like Norges Bank, Sveriges Riksbank has a Supervisory Council and an Executive Board. The Supervisory Council is as in Norway elected by Parliament. However in Sweden it is the Supervisory Council that names the Executive Board. In Norway the government names the Executive Board of Norges Bank. The political parties represented in the Storting nominate candidates for the Executive Board. The Government has only on rare occasions opposed these nominations.
The law states the following about the official reports from Norges Bank to the government (section 28):
• “The Executive Board shall each year prepare an annual report and accounts for the year. […]
• The annual report and the audited annual accounts, as well as the statement of the Supervisory Council on the minutes of meetings of the Executive Board, are sent to the ministry for submission to the government and communication to the Storting. A communication from the ministry to the Storting concerning activities in Norges Bank shall be made at least once during each Storting session, and more frequently if special circumstances dictate. […]”
Norges Bank is supposed to file a yearly statement. In Sweden the Board is expected to present reports on monetary policy twice a year. Like e.g. Bank of England Norges Bank is responsible to report to the government, not to Parliament. However, the reports shall be made available to the Storting. The Storting shall also receive a report from the government on the work of the Bank. The government’s duty to inform the Storting is not limited to the yearly statements if special circumstances occur.
According to section 6 the Executive Board is obliged to keep minutes from their meetings. These are at the time being not made available to the public.
It has been seen as standard practice to publish board minutes in a number of inflation targeting regimes, including the UK and Sweden.
3.2 The monetary policy guidelines
The Norwegian government 29 March 2001 adopted a new regulation of monetary policy. Section 1 reads:
• “Monetary policy shall be aimed at stability in the Norwegian krone’s national and international value, contributing to stable expectations concerning exchange rate developments. At the same time, monetary policy shall underpin fiscal policy by contributing to stable developments in output and employment.
• Norges Bank is responsible for the implementation of monetary policy.
• Norges Bank’s implementation of monetary policy shall, in accordance with the first paragraph, be oriented towards low and stable inflation.
The operational target of monetary policy shall be annual consumer price inflation of approximately 2.5 per cent over time.
• In general, the direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and extraordinary temporary disturbances shall not be taken into account.”
In addition the Storting Report no. 29 of 2001 states:
• “Consumer price inflation is expected to remain within an interval of +/- 1 percentage point around the target.”
Through a number of speeches and articles the Norges Bank Governor, Svein Gjedrem, has made clear how Norges Bank will implement this new regulation. These comments should give a fairly good insight in how Norges Bank will proceed when conducting monetary policy.10
• “If evidence suggests that inflation with unchanged interest rates will be higher than 2.5 per cent, the interest rates will be increased. If it appears that inflation with unchanged interest rates will be lower than 2.5 per cent, the interest rates will be reduced. There is symmetry here.”
• “Our analyses indicate that a substantial share of the effects of an interest rate change occurs within two years. Two years is thus a reasonable time horizon for achieving the inflation target of 2.5 per cent.
This means that interest rates are set with a view to achieving an inflation rate of 2.5 per cent two years ahead.”
10 All citations from Aftenposten, 29 May, 2001, except number 5 that is from Dagens Næringsliv, 6 July, 2001.
• “In some situations where unexpected events lead to an inflation that is too high, it may be appropriate to apply a longer time horizon than two years. For example, reducing inflation to 2.5 per cent within this time horizon may be associated with unnecessary real economic costs. A precondition for applying a longer time horizon is that there is clear evidence of strong confidence in low and stable inflation over time on part of the economic agents.”
• “Developments in financial and property markets can be a source of a more unstable inflation environment. In principle, it would be appropriate to use the interest rate to counter this. In practice, however, it is difficult to assess whether property and financial asset prices are sustainable.”
• “[…] Norges Bank will normally proceed with caution in connection with any interest changes in response to fluctuations in the exchange rate. A special situation arises if strong turbulence in the foreign exchange market indicates that confidence in monetary policy is in jeopardy. A rapid and pronounced change in the interest rate may then be appropriate.”
• “When Norges Bank concludes that a change in the key rate is appropriate, the change will in most cases be made gradually.”
• “Norges Bank analyses the inflation prospects in its Inflation Report, which is published three times a year.”
• “The Government has assigned a task to Norges Bank. Norges Bank uses its professional judgement in a delimited area. The results of our decisions can be measured. Hence the government authorities can evaluate our performance.”
It should be noticed that the regulation of monetary policy in Norway probably puts more weight on the medium and long-term stability of the nominal exchange rate than what is usual in most inflation targeting regimes.
One can also point out that the Norwegian inflation target of 2.5 per cent is slightly higher than in Canada, New Zealand, Sweden and the Euro area. It is however in line with the target in the United Kingdom and Australia.
3.3 The Norwegian system compared with best practice
There are three important differences between the Norwegian system and the
“best practice” described in section 2.
1. The Norwegian government has an explicit right to instruct Norges Bank. This might reduce the accountability of the Bank.
2. Political parties nominate candidates to the Executive Board of Norges Bank. This can affect the political independence of the Bank.
3. There is a special focus on nominal exchange rates in the economic policy statements made by the government. Further the Norwegian inflation target is somewhat higher than in many other inflation targeting regimes.
Do these “anomalies” have potentially negative effects for the stability and effectiveness of the Norwegian inflation-targeting regime? Do they come with a real economic cost?
The right to instruct the bank
As pointed out above the standard interpretation of this clause is that it is only to be used in the most extreme situations. One can argue that a legal opportunity to instruct the central bank makes the central bank more vulnerable for meddling than a regime where the independence of the central bank can only be threatened by changing the law. However, in practice no country would allow a central bank to act in opposition to the government over time, so some right of instruction will always exist.
The current text might be interpreted as a division of responsibility for monetary policy between Norges Bank and the Government. The Government can not look back and criticise the stance of Norges Bank as wrong, since the Government, if it actually believed Norges Bank to be wrong, should have instructed the Bank to change course. A strength of the system is that the Government must commit to stand behind how monetary policy is conducted. But there are also problems. On one hand it might be easier for the Government to influence the positions of the Bank through informal channels using the right of instruction as “a threat”. On the other hand the Government might lose some of its force when evaluating the conduct of Norges Bank ex post. The right of instruction can become a liability for the government if it is supposed to hold Norges Bank accountable for monetary policy.
There exist rights of instruction in other inflation targeting regimes. UK legislation provides that if, in extreme circumstances, the national interest demands it, the Government will have the power to give instructions to the Bank on interest rates for a limited period. The right can be exercised only through subordinate legislation approved by Parliament. However, the Norwegian right of instruction is more general. It might seem especially strange to keep the right to instruct the Executive Board in specific cases if the process of choosing members to the Board is changed, as we suggest below. That would imply that the Government does not trust its own experts.
However, given the present non-use of this clause, a change would probably not make much of a difference for the actual independence of the Bank.
The Executive Board
In an inflation targeting regime the interest rate should be based on a sound understanding of how to reach the long-term goals of the central bank.
Interest rate decisions must therefore be based on two important criteria:
• competence in understanding the long-term impact of central bank instrument, and
• independence from influence that is not in accordance with the goals of the bank.
Most inflation targeting regimes have chosen a system where the interest rate decisions are taken by a board to secure a broad discussion of monetary policy before instrument use is decided.
Two questions need to be discussed:
• Should the board consist of experts or non-experts?
• How should the board be appointed?
An argument used by Svensson (2001) is that experts could easily dominate non-experts. A consequence could be that a board consisting of non-experts would not be sufficiently able to questions the central bank’s professional assessments. On the other hand we might imagine that a board consisting only of experts could be too focused on “mainstream economic theory” to understand the real economic consequences of their actions.
Another argument for a board of experts is central bank independence.
Politicians will appoint every board. But members of a board of experts will be appointed as experts, and will be held responsible if they do not act as such. If a board consists of people with mainly political experience, such members might be criticised if they do not follow a political line in their voting on the board. Both Sweden and the United Kingdom have only experts at their Executive Boards.
In Norges Bank the five members of the Board who are not part of the Bank’s leadership are in all but name the appointees of political parties. It is, at the present time, difficult to give a fair assessment of how the current system of nominations will work under the new monetary regime. Until the end of 1998 Norwegian monetary policy was concentrated on stabilising the nominal exchange rate. Under that regime the Board had little influence on actual monetary policy. This might have affected the choice of candidates to the Board. A reasonable assumption is that the political parties in the future
will pick their candidates with care so as to provide a strong and able Executive Board of Norges Bank. However, unlike a government or a parliament a political party has a narrow scope. This might create uncertainty around some nominees. It is also possible that political appointments might be the target of political pressure if minutes from board meetings are published.
The current system seems to have given the Governor a strong position at Board meetings. It is the Bank’s Governor, not the Board, who is held accountable for monetary policy to the public. However, it is difficult to believe that any board would suggest a monetary policy that is not in line with the Inflation Reports of the Bank. Even a board consisting of only highly skilled economists would not have the resources to effectively present an alternative analysis to that of the Economics Department in the Bank. But it is important that the Board is able to ask critical questions to the analysis made by the Bank. Over time an effective board would be a board that forced the staff of Norges Bank to continuously make fresh reflections on how the economy works and how monetary instruments should be applied. It is also important that the questions asked reflect the real concerns among the Norwegian population. A well-qualified and representative Board can assure that the public remains confident in the Bank’s analysis.
We believe that the current practice of appointing members to the Executive Board is sub-optimal. If political parties in everything but name appoint candidates to the Board this can increase the risk of factors other than competence being important when electing Board members.
Should this imply that the government instead names a Board consisting of only trained economists? People with the right experience do not need a degree in economics to have informed opinions about monetary policy. The only formal requirement should be that a Board member has the skills necessary to understand the work of Norges Bank. Effort should probably be made to assure that the Board does reflect a broad sample of backgrounds.
Given the small number of academic economists in Norway and the close connection between academic circles and Norges Bank, we would argue that Board membership should not be limited to academic economists.
It might well be that political parties should continue to nominate candidates.
It is however important that the parties take care to find persons who fulfil the above criteria. The parties should also nominate a number of qualified candidates, giving the government a real choice when choosing members to the Executive Board. We would like to add that if a Board were to be
appointed purely on the basis of skill it would be natural to publish the minutes from Board meetings.
3.4 The focus on nominal exchange rates and the inflation targets – is the economic policy guidelines consistent in the long term?
In the new regulation of the Norwegian monetary policy, the two first sections read:
“Monetary policy shall be aimed at stability in the Norwegian krone’s national and international value, contributing to stable expectations concerning exchange rate developments. At the same time, monetary policy shall underpin fiscal policy by contributing to stable developments in output and employment.”
Norges Bank’s implementation of monetary policy shall, in accordance with the first paragraph, be oriented towards low and stable inflation.(…) The operational target of monetary policy shall be annual consumer price inflation of approximately 2.5 per cent over time.
Does this imply a possible inconsistency in the Norwegian monetary regime? As we know, most of our trading partners have inflation targets below 2.5 per cent. The Norwegian regulation of monetary policy seems to imply an expectation of a real appreciation of the Norwegian exchange rate through prices instead of nominal exchange rate adjustments.
The planned increased domestic usage of oil revenues should be expected to cause a real appreciation of the exchange rate. Production resources need to reallocated, as the demand for domestic services rise. This creates a demand for change in relative prices. Such a change can come either through a nominal exchange rate appreciation or a relative shift in the Norwegian price level compared with our main trading partners. Our main trading partner, Euroland, seems (in effect) to have an inflation target between 1.5 and 2 per cent. Sweden has an inflation target of 2 per cent. Given a stable exchange rate, the Norwegian inflation target has a ½ per cent (or somewhat above) implied real appreciation built into the mandate.
Norges Bank has stated that it will not allow high domestic inflation to facilitate the real appreciation of the Norwegian krone. It is possible that a real appreciation of a ½ per cent is exactly what is needed in order to
accommodate the increased spending of oil revenues. But there are considerable uncertainties here.
Domestic spending of oil revenues is a very important political topic. The bank’s assessment of the impact of a more expansionary policy is vital, both for the fiscal authorities and for the market participants. The Bank should not be expected to publish precise exchange rate forecasts. However, the Bank should attempt to illustrate the combined impacts of changes in fiscal policy and interest rate responses given different exchange rate profiles. Such a clarification can help stabilise long-term expectations for the nominal exchange rate. That might reduce the short-term volatility in exchange rate.
4. Can the high Norwegian interest rates be justified?
4.1 Norwegian nominal and real rates are higher than in Euroland
The most striking aspect of the Norwegian monetary policy in the past year is that interest rates have been far above interest rates in almost all other industrialised countries. We start the discussion on the monetary policy from this position.
In fact, Norwegian interest rates have remained far above Euroland level for a long period of time, see figure 4.1. The key sight deposit rate of the Norwegian Central Bank has been maintained at a high 7 per cent rate since September 2000, while ECB has cut its signal rate from 4.75 per cent to 3.75 per cent. Currently (September 21), the 3-month Nibor interest rate is 6.94 per cent, while the yield on long term (10 years) government bonds is 6.4 per cent. This implies that the interest differentials versus Euroland amount to almost 3.5 percentage points for corresponding 3-month interest rates and 1.5 percentage points for 10 years government bonds, see figure 4.2 How can these high Norwegian interest rate levels and interest rate differentials versus Euroland be justified?
Figure 4.1
3 months Euro interest
Jul 97 Jul 98 Jul 99 Jul 00 Jul 01 Jul
0 1 2 3 4 5 6 7 8 9
0 1 2 3 4 5 6 7 8 9
en
Norway
Germany/EM
Differentia
It is useful to adopt a rather broad perspective and consider this issue in the present chapter, before we turn to a more detailed discussion of the interest rate setting and communication of the Norwegian Central Bank in the next chapter. As a point of departure, we note that Norwegian core inflation is running at or somewhat below 2.5 per cent y/y rate for the moment. The corresponding headline rate is 2.7 per cent y/y. The equivalent annual inflation rates in Euroland are 2 per cent and 2.6 per cent respectively. Thus, inflation is not much higher than in Euroland. The difference between nominal rates are almost entirely due to difference in real interest rates.
According to projections in the latest inflation report of the Norwegian Central Bank, maintenance of the current level at 7 per cent of the key interest rates is consistent with 2.5 per cent annual inflation in 2003 – just as targeted.
Figure 4.2
10 y Government bond yields
Jul 97 Jul 98 Jul 99 Jul 00 Jul 01 Jul
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
n
Norway
Germany/EM
Differentia
4.2 The short-run macroeconomic picture - Binding capacity constraints
The Norwegian economy is working very close to full capacity. This is most clearly illustrated by the developments in the labour market. The unemployment rate has been stable at levels between 2.5 and 3 per cent of the labour force according to figures from the public labour market office or
somewhat above 3 per cent measured by the Labour market survey (Arbeidskraftundersøkelsen, see figure 4.3).
Figure 4.3
Unemployment, Norway vs. EMU
93 94 95 96 97 98 99 00 01
0 1 2 3 4 5 6 7 8 9 10 11 12 13
0 1 2 3 4 5 6 7 8 9 10 11 12 13
FIRST
EMU
Per cent of the labour force
Norway
Comparing with unemployment rates around 9 per cent in the largest Euroland economies, we conclude that such a huge difference must matter for differences in the underlying inflationary pressure. Hence, we believe that this accounts for stronger wage–costs impulses in Norway than in Euroland – even if we take into account that the NAIRU (The Non- Accelerating-Inflation-Rate-of-Unemployment) is much lower in Norway than in Euroland and that the highly co-ordinated wage-setting in Norway has (so far) been fairly successful in terms of avoiding excessive nominal wage increases.
The actual and potential strength of aggregate demand in the Norwegian economy is strong compared to many other OECD countries for the moment.
This is mainly due to the financial position of the oil-rich Norwegian public sector. In Norway, the government collects in effect approximately 90 per cent of the net cash flow from the petroleum sector due to taxation and direct involvement in the sector. According to the petroleum fund strategy of the government, the income from the petroleum sector is allocated to a well- diversified portfolio of foreign financial assets. Currently, the petroleum fund amounts to more than 500 billions NOK, or approximately 45 per cent of mainland GDP, and the size of the fund is increasing fast. The petroleum
fund strategy is accompanied by a brand new explicit “spending rule”, which states that an estimated 4 per cent real return on the financial assets should be spent every year – on average.16 This fairly conservative spending rule, which implies increasing consumption of petroleum-income over time, means that:
• Fiscal policy will give a constant demand-stimulation in many years to come. Moreover, it is not hard to imagine situations where the outcome of the political negotiations about the fiscal budget will lead to more fiscal stimulus than implied by the spending rule.
• The fiscal strategy is consistent with a real appreciation involving transfers of resources from sectors producing tradeables to sectors producing non-tradeables.
The potential strength of Norwegian private demand is also more impressive than in most other OECD economies even though recent figures on, for example, retail sales volume and car sales indicate that the high interest rate level curbs the spending level somewhat. We observe that the financial position of the total household sector is excellent, the household saving rate is at a fairly high 6.5 per cent level, workers are enjoying a very high degree of job market security, the wage growth has been satisfactory and the prospects for (minor) tax cuts seem good. Thus, it is very hard to imagine any significant downward adjustment of consumer demand in the short and intermediate run.
The overall short-run macroeconomic picture in Norway is characterised by strong domestic demand impulses and binding capacity constraints on the supply side. In addition to the very tight labour market, productivity growth has been very low in the last couple of years as well. The current fairly favourable inflationary picture reflects that fiscal discipline has been satisfactory, while the fairly high nominal interest rates contribute to keep private demand growth in check. Looking ahead, our assessment is that interest rates must remain significantly above the Euroland level in the next couple of years because
i) the domestic demand pressure is likely to remain stronger in Norway than in Euroland and ii)
ii) the capacity level on the supply side is not likely to improve much over such a horizon.
16 The government stresses that business cycle conditions may lead to temporary deviations from this strategy.
